Nonprofit Boards and Alternative Investments

Few are willing to acknowledge that if they cannot understand an investment product, then they won't buy that product.

W. Scott Simon

 

One of the great tenets of modern prudent fiduciary investing is that no investment under consideration for inclusion in a portfolio is prudent or imprudent per se. The Prefatory Note to the 1994 Uniform Prudent Investor Act (UPIA) states, in part: “[The UPIA] makes five fundamental alterations in the former criteria for prudent investing. All are to be found in the [1992] Restatement [(Third) of Trusts from which the UPIA is derived].” One of these alterations is that “[s]pecific investments or techniques are not per se prudent or imprudent. The riskiness of a specific property, and thus the propriety of its inclusion in the trust estate, is not judged in the abstract but in terms of its anticipated effect on the particular trust’s portfolio.” (Restatement (Third) of Trusts (Prudent Investor Rule), section 227, comment f, page 24.)

Section 2(e) of the UPIA states: “A [fiduciary] may invest in any kind of property or type of investment consistent with the standards of [the UPIA]. … The premise of [UPIA] subsection 2(e) is that trust beneficiaries are better protected by the [UPIA’s] emphasis on close attention to risk/return objectives as prescribed in [UPIA] subsection 2(b) than in attempts to identify categories of investment that are per se prudent or imprudent.” (Restatement (Third) of Trusts (Prudent Investor Rule), section 227, comment f, page 24.)

Fiduciaries subject to a state’s statutory adaption of the UPIA are no longer permitted to make investments on the basis of some statutorily sanctioned list of preapproved investments, such as Treasury notes or bank certificates of deposit. In addition, even though no particular investment or type of investment is to be pigeonholed as “prudent” or “imprudent” in the abstract, that’s not to say that a fiduciary cannot conclude in a particular situation that an investment it is considering for inclusion in a portfolio must be rejected because it’s just “too risky.” In fact, a fiduciary responsible for some portfolio of money will, as a practical matter, pretty quickly narrow down the investments that he or she would likely consider including in the portfolio.

This brings me to the inclusion of alternative investments in portfolios run by nonprofits. Many boards of trustees at nonprofits with pools of money north of, say, $25-$50 million have been targeted over the last decade or so by large consulting firms that have advised them to invest in so-called alternative investments. I’ve run across a number of instances like this and thought that my observations might be of interest to advisors who are already active in the nonprofit arena and those who would like to get into it.

Nonprofit Boards of Trustees

Many trustees who are on the boards at nonprofits have an emotional bond with their nonprofit and the mission it seeks to fulfill. That’s why they’re very willing to donate so much of their time and energy to helping carry out that mission. These trustees are always very successful people in their community–which is one very good reason why they’re asked to be on the boards at nonprofits in the first place.

Although they’ve been successful in their respective fields, many are usually not experts in investing. The only experience that these trustees have had is to intone the usual mantras of active investing: “Smart” experts can beat the market; or, because this or that mutual fund (or whatever form of investment) has had a stellar track record of performance (over whatever period), it will naturally continue in that vein in the future; or, no self-respecting investor should be caught not holding Facebook stock, and the like.

Some trustees with this worldview of investing can be easy marks for some of the large national consulting firms (as well as others) that provide advice to boards at many larger nonprofits in America. The individual advisors at these firms are always nice and very likable people; indeed, that’s precisely why they are selected as advisors to the boards in the first place. (Personally, I’ve never met a highly paid advisor who isn’t a likeable person.)

What often makes it easy for these advisors when they are pitching complex investment products such as alternative investments to boards at nonprofits is that only a relative few board members (most of whom, in fact, are quite intelligent) actually understand them. Few are willing to acknowledge, as Warren Buffett did in the lead-up to the tech meltdown in 2000, that if they cannot understand an investment product, then they won’t buy that product.

As a result, many members on the boards at nonprofits simply “go along to get along” and agree to whatever investment recommendations their advisors make for fear of admitting in front of their fellow board members that they have little idea how any given investment (especially those with unfamiliar names such as a “privately-traded REIT”) that’s being touted by their advisors can actually contribute (in the words of the Restatement) “in terms of its anticipated [risk and return] effect [to] the particular trust’s portfolio.”

So when many investment advisors to nonprofits–who themselves are not particularly expert at investing other than expert in the sales of investment products–turn on the sales charm, the trustees at nonprofits normally accede with little analysis (or even protest) to whatever investment products the advisors are currently pushing to be included in a nonprofit’s portfolio.

Alternative Investments

The late Gordon Murray, a former investment banker on Wall Street for nearly three decades (and whose book I reviewed for Morningstar) offered a highly useful warning to fiduciaries responsible for other people’s money (including board members at nonprofits) when he noted that the more complex and difficult to understand an investment product, the greater the compensation that will be paid to the salesperson peddling that product. (As I noted in my review, Murray’s paper on the interplay between Wall Street and Main Street, written five years before the market meltdown in 2008, is by far the most clear and concise that I have ever read.)

Over the last decade or so, there has been an acceleration in the sale of investment products known as “alternative investments” to institutional investors, including nonprofits. Although there’s no common agreement as to what actually constitutes an alternative investment, those most often mentioned include hedge funds, private equity deals, and privately-traded REITs. More and more nonprofit portfolios have come to include such investments (as have many public pension funds eager for the touted higher returns of alternatives but blind to the higher risks that are always on the other side of the risk-return trade-off). The only problem with many “alternatives” is that they often generate mediocre investment performance (despite claims that their managers are geniuses), can be quite costly, are often difficult to understand, lack transparency, are often illiquid and/or are often impossible to value. But such sweeping assessments would not be in accord with the tenets of modern prudent fiduciary investing noted earlier in this column. Instead, the prudence of such investments (or any investment) must be assessed on a portfolio-by-portfolio basis.

Next month’s column will delve a bit deeper into alternative investments in nonprofit portfolios and suggest some questions that advisors may wish to pose to nonprofit boards about them.

W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.

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